Are performance-linked fees coming to Indian mutual funds? That will be a sad day for the Indian investor.
23-May-2023 •Dhirendra Kumar
According to some news stories, SEBI is considering a proposal to allow performance-linked fees in mutual funds. Currently, mutual funds charge a flat percentage of the money they manage, regardless of whether investors have high returns, low returns or losses. From what has been heard about the new proposal, funds will have the option of charging by a different structure, which includes some kind of a performance fee. In the world of investment management, a performance fee means that the fund gets a percentage of the returns. Thus, the higher the returns, the higher the amount they earn. Generally, most - but not all - such funds also charge a management fee.
How does all this work? This is best illustrated through an example. The fee structure is often expressed as three numbers, for example, 2/8/20. This particular example means that the fund will charge a management fee of 2 per cent per annum plus 20 per cent of that part of the returns that exceed 8 percent. The 8 per cent is called the hurdle rate. This rate may seem like robbery to an Indian mutual fund investor, but I can assure you it's quite common. After a few years, ALL performance fees feel like robbery because they are.
The fund management industry says that performance fees are a good thing because they align the interests of the investors and the fund - if the investors make more money, then the fund makes more money. This idea is utterly dishonest nonsense. A corrected version would be: in those years, when the investors make more money, the fund makes more money, but in those years, when the investor loses money, the fund makes a little bit of money (the management fee). Even if the management fee is zero, the fund does not lose money. The fund is a partner in your profits but not in your losses. Does this sound like an 'alignment of incentives' to you? No, calling it an alignment is a cruel joke.
One big reason is that if the fund management takes more risks, it skews the numbers towards robbing the investor. Every equity investor knows that by taking higher risks, you can get higher volatility. That is, you can get periods of much higher returns at the cost of deeper losses during the loss-making periods. Since performance fees make the fund a partner in your profits but not in your losses, this is a neat way for funds to make more money. In the global markets, years of underperformance have forced some funds to offer some fixes to this, but the fact remains that investors make less money than they otherwise would.
There is another big problem, which is that performance fees bleed the invested amount continuously. All the money deducted by funds in the profitable years is not available for further growth, thus lowering further returns. In fact, this makes equity funds like fixed deposits, where the government deducts TDS every year, thus lowering returns.
In any case, this annual deduction from the entire fund, which is the 'global standard' is deeply hostile to investors and completely contrary to the spirit of mutual fund investing. If at all, the performance fee should be tiny and a one-time fee deducted when the investor redeems his investment in the manner of an exit fee.
Is there any justification for performance fees at all? The one-word answer to that is NO. Those who have observed the fund industry for a long time know that there is already an effective performance incentive of the best kind. Funds that have done well historically get more money. They get more customers as well as more additional investments from happy customers. As assets grow, so does the management fee and, thus, the profits made by the fund company. The performance incentive generated by happy and satisfied customers is the most stable and long-lasting. The regulator should encourage this kind of incentivisation instead of being party to this conspiracy of picking customers' pockets through a sham 'alignment of incentives.'